MiFID 2, MiFIR and Commodity Derivatives
The final texts of MiFID 21 and MiFIR2 were published in the Official Journal of the EU on 12 June 2014 and entered into force 20 days later on 2 July 2014. Entry into application will follow on 3 January 2017.
The main changes made by MiFID 2 and MiFIR in relation to commodity derivatives are:
- extended scope – more commodity derivatives will be brought within the regulatory perimeter;
- exemptions – the number of exemptions available to entities trading commodity derivatives will be restricted; and
- position limits and reporting – new position limits, management controls and position reporting requirements with the grant of additional intervention powers to the European Securities and Markets Authority (ESMA).
Physically settled commodity derivatives traded on an OTF and REMIT wholesale energy products
Under MiFID3, contracts traded on a Regulated Market (RM) or Multilateral Trading Facility (MTF) that can be physically settled are “MiFID instruments” and therefore within the regulatory perimeter. Under MiFID 2, section C(6) of Annex 1 to MiFID is extended to cover physically settled commodity derivatives traded on an Organised Trading Facility (OTF). There is a carve-out for wholesale energy products as defined in REMIT4 traded on an OTF which must be physically settled. Competent authorities can also give temporary exemption from EMIR5 clearing obligations and thresholds for physically settled oil/coal derivatives traded on an OTF.
Commodity derivatives “having the characteristics of other derivative financial instruments”
In relation to section C(7) of Annex 1 to MiFID, ESMA has now published its proposals for what “having the characteristics of other derivative financial instruments” means. This will depend on the level of standardisation of the contract and whether the contract is traded on a third country trading venue that performs a similar function to any of the MiFID 2 trading venues; is expressly stated to be traded on or subject to the rules of any of the MiFID 2 trading venues or a third country trading venue; or is equivalent to a contract traded on a MiFID 2 trading venue or a third country trading venue with regard to the price, lot size, the delivery date or other terms. There are exemptions from this category for contracts under which delivery of the underlying commodity is scheduled to take place within the longer of two trading days from execution of the contract or the period generally accepted in the market for that commodity as the standard delivery period. Contracts which are entered into for commercial purposes are also exempt.
For the purposes of MiFID 2, emission allowances (EUAs) will become financial instruments. However, the definition of “commodity derivatives” does not include EUAs which means that the provisions on position limits and position management controls for derivatives in MiFID 2 and MiFIR will not apply (as to which, see further below). Spot EUAs will not be in scope of the various EMIR obligations but derivatives on EUAs will be.
The Article 2(1)(d) exemption on dealing on own account has been amended so as not to apply to dealers in commodity derivatives, EUAs and derivatives on EUAs.
The Article 2(1)(k) exemption for dealers whose main business consists of own account dealing in commodities or commodity derivatives has been deleted, effectively bringing many commodities dealers who currently rely on this exemption within the regulatory perimeter for the first time.
The Article 2(1)(i) exemption is retained for ‘ancillary activities’ but the exemption will now only be available to firms which deal on own account other than by executing client orders in commodity derivatives and/or provide investment services other than dealing on own account to the clients of their main business. Those wishing to rely on the exemption will also have to show (a) that the two permitted activities are ancillary to their main business on a group basis; (b) that their main business is not the provision of investment services under MiFID, banking services under the Banking Consolidation Directive, nor acting as a market maker in relation to commodity derivatives; and (c) they do not apply a high frequency algorithmic trading technique.
Position limits and reporting
Competent authorities will impose position limits on the size of the net position that a person can hold in commodity derivatives traded on a trading venue and economically equivalent OTC contracts. These limits will be set on the basis of all positions held by a person and those held on its behalf at an aggregate group level.
Limits will not apply to positions held by or on behalf of a non-financial entity, and which are objectively measurable as reducing risks directly related to the commercial activity of that non-financial entity.
ESMA has produced draft regulatory technical standards in relation to position limits and will publish further details in its next consultation paper on MiFID 2 draft technical standards.
Position management controls
Operators of trading venues trading commodity derivatives will also have to apply position management controls. These will include powers to monitor open interest positions; access information about the size and purpose of a position; require a person to terminate or reduce a position; and, where appropriate, require a person to provide liquidity back into the market.
Operators of trading venues trading commodity derivatives must report aggregate positions by class of persons, including daily breakdowns of positions (e.g., by participants, clients, clients of clients) to competent authorities and a weekly report of the aggregated positions held by different categories of position holders for the different contracts traded on that trading venue.
MiFIR allows ESMA to request all relevant information from any person regarding the size and purpose of a position or exposure entered into via a derivative. ESMA may then require such persons to reduce the size of or to eliminate their position or exposure or may limit the ability of a person to enter into a commodity derivative. ESMA may only take these steps if there is a threat to the orderly functioning and integrity of the financial markets or to the stability of the whole or part of the EU financial systems and a competent authority has not taken measures or the measures taken are inadequate to address such threat.
In addition, ESMA will have powers of supervision and intervention in relation to the marketing, distribution and sale of financial instruments or types of financial activity or practice.
The impact of the MiFID 2 on commodity derivatives firms is significant. As identified above, some firms that were not previously subject to regulation will now be brought within the regulatory perimeter. Where a firm is no longer able to rely on an exemption, it will need to become authorised to carry out the relevant MiFID 2 business and put in place systems to ensure compliance with the applicable rules.
In addition, the introduction of position limits and reporting obligations will impose substantial operational burdens on firms.
Directive 2004/39/EC on markets in financial instruments.